What Happens When Only One Partner Wants to Exchange?
A partnership may exchange property for other property of “like kind.” However, IRC Section 1031(a)(2)(D) specifically prohibits exchanges of partnership interests. This means that a 1031 Exchanger cannot buy into or sell interests in a partnership and qualify for a §1031 exchange. The rationale is that a partnership interest [along with a real estate investment trust (REIT) share] itself is personal property and thus is not “like-kind” with real property. Given these facts, what alternatives are available to 1031 Exchangers?
Is it a “true” Partnership?
First, investors owning a property together must determine if they really own the property in a true “partnership.” Often, investors who own property with others may consider the other individuals their “partners” even though they hold the title as an undivided interest and don’t file a partnership tax return, thus they are mere “co-owners.” The test is generally, “do the owners hold the title as “tenants-in-common?”
Potential 1031 Exchange Alternatives
One option is that the entire partnership stays intact and exchanges the relinquished property for a replacement property, the property can be refinanced and the proceeds are distributed to the partner who wants to cash out.
Another alternative is that the partnership has a valid election out of subchapter K under IRC §761. The partner seeking to cash outsells their undivided interest and the other partner exchanges their tenancy-in-common interest for a replacement property. (Note: There are risks associated with partnership issues that must be discussed with a legal and/or tax advisor.)
Additional 1031 Exchange Considerations
- Advance planning is important, as the greater the period of time between the election out of the partnership and the exchange the better. The election out of the partnership to the individuals as an undivided interest shortly before closing on the relinquished property leaves open the possibility that the exchange would be invalidated because the property was not held as an undivided interest long enough to be considered “held for investment.” [Note: In several instances, however, the Tax Court has extended 1031 tax deferral to former partners who changed their ownership structure prior to closing on a relinquished property.]
- If the entire partnership will be exchanged, it is preferable that the Partnership Agreement mention that they are holding the property “for investment or use in a trade or business.”
- Every 1031 Exchanger should always consult with their legal and/or tax advisors to review the many issues and risks involved with partnership situations. Contact 1031 Exchange Place toll-free to discuss partnership issues in greater detail.